Investment interest is interest paid or accrued on indebtedness incurred to purchase or carry property held for investment (Sec. 163(d)(3)(A)). Investment interest does not include qualified residence interest or interest incurred in a passive activity (Sec. 163(d)(3)(B)). However, if a passive activity generates portfolio income (interest, dividends, etc.), the portion of the passive activity interest expense allocable to the portfolio income is investment interest rather than passive activity interest (Notice 89 - 35 ; IRS Letter Ruling 9037027).
Property held for investment includes any property producing interest, dividends, annuities, royalties, and gain - generating property other than that used in a trade or business activity or passive activity. Investment property also includes an interest involving the conduct of a trade or business that is not considered a passive activity but in which the taxpayer does not materially participate (generally, oil and gas working interests in which the taxpayer does not materially participate) (Sec. 163(d)(5)). Income from these properties increases investment income, while deductions (including net losses from oil and gas working interests treated as investment property) related to them reduce investment income.
Taxpayers with oil and gas working interests must consider these rules if they are subject to investment interest expense limitations. If the taxpayer does not materially participate in the working interest, the net income or loss will impact investment income. Thus, taxpayers who do not materially participate in a working interest that generates a net loss must reduce their net investment income by the net loss. These taxpayers may benefit by taking steps that would allow them to meet the material participation standard for the activity so the net loss does not reduce their allowable investment interest expense.
Investment interest expense does not include interest expense that is capitalized (e.g., under Sec. 263A) or interest expense related to tax - exempt income that is not deductible under Sec. 265(a)(2). This rule also applies to mutual funds so that if a fund invests in both taxable and tax - exempt securities, the interest expense must be allocated proportionately based on the income from the fund. Prepaid interest on a margin account is generally not deductible in the year paid (unlike other itemized deductions, such as state income or real estate taxes); instead, it is carried forward and deducted in the year when it properly accrues (Sec. 461(g); Rev. Rul. 68 - 643 , as modified by Rev. Rul. 69 - 582 ).
Interest expense incurred by a trader who materially participates in the trading activity is not subject to the investment interest expense limitations (King, 89 T.C. 445 (1987)). Whether a taxpayer is a trader or investor generally depends on the amount of trading activity and other factors.
If funds from a home - equity loan are used to purchase taxable investment securities, and the taxpayer has sufficient investment income to deduct the interest as investment interest, the taxpayer should consider using the tracing rules of Temp. Regs. Sec. 1. 163 - 8T to classify the interest as investment interest since the deduction for home - equity interest is suspended from 2018—2025 (Sec. 163(h)(3)(F)(i)).
Caution: No guidance has yet been issued on using the tracing rules of Temp. Regs. Sec. 1.163-8T to reallocate home-equity interest that has been disallowed by Sec. 163(h)(3)(F)(i). Practitioners should be alert for future developments.
Investment interest is deductible as an itemized deduction but limited to net investment income. Net investment income is defined as the excess of investment income over investment expenses (Sec. 163(d)(4)(A)). Investment income includes (1) gross income from property held for investment (e.g., interest), (2) the excess of any net gain over any net capital gain resulting from the disposition of investment property, and (3) as much of the taxpayer's qualified dividend income and net capital gain from the disposition of investment property as he or she elects to include (see the following discussion of the election). Investment expenses are the deductions allowed (other than interest) that are directly related to the production of investment income (Sec. 163(d)(4)(C)).An expense subject to the 2%- of - adjusted - gross - income (AGI) limitation on miscellaneous itemized deductions is considered only to the extent a deduction is allowed.
Observation: With the disallowance of investment expenses under Sec. 212 from 2018—2025 (as part of the general disallowance of miscellaneous itemized deductions subject to the 2%- of - AGI floor under Sec. 67(g)), investment income will have few, if any, offsets in the calculation of net investment income in these years.
For item (2) above, only dispositions of property held for investment are considered (i.e., Sec. 1231 gains treated as long - term capital gains are not considered), and net gain refers to the net gain from all investment assets whether short - term or long - term . Capital loss carryovers must be considered when computing net gain (IRS Letter Ruling 9549002). Net capital gain refers to the excess of net long - term capital gain over net short - term capital loss. The intent is to exclude net capital gains (i.e., gains taxed at favorable capital gains rates) from investment income unless the taxpayer elects to include all or part of these.
Sec. 1277 contains a little - known rule that can cause a deferral of part of the interest expense traced to debt - financed investments in taxable market discount bonds (MDBs). It applies to MDBs acquired after July 18, 1984. (The rule does not apply to debt - financed tax - free MDBs because the interest to carry tax - free investments is not deductible anyway (see Secs. 265(a)(2) and 1278(a)(1)(C)).) The effect of the rule is that the portion of a taxpayer's otherwise deductible interest expense allocable to the tax year's accrued market discount may be disallowed for the tax year. The disallowed amount (if any) is then deductible as interest expense in one or more later years (Sec. 1277(b)(2)).
Electing to include qualified dividend income and net capital gains in investment income The definition of net investment income excludes qualified dividend income and net capital gains (i.e., the excess of net long-term capital gains over net short-term capital losses) unless the taxpayer elects to include all or part of these in investment income (Sec. 163(d)(4)(B)). The election for gains is available only for net capital gains resulting from the disposition of property held for investment. (Sec. 1231 gains treated as long-term capital gains are not available for the election.)
If the election is made, the amount of qualified dividend income and net capital gain included in net investment income is no longer eligible for the favorable capital gains rates. In effect, this causes the elected amount to be treated as ordinary income and potentially taxed at rates as high as 40.8% (37% + 3.8% net investment income tax). The election is made on or before the due date (including extensions) of the income tax return for the tax year in which the net capital gain is recognized or the qualified dividend income is received (Regs. Sec. 1.163(d)- 1 (b)).
The election to include net capital gain is limited to the lesser of (1) net capital gains from property held for investment or (2) net gains from property held for investment. For example, an investor with a net capital gain of $5,000 and a Sec. 1244 ordinary loss of $3,000 has a net gain of $2,000. Thus, the amount eligible for the election is limited to $2,000.
When the election is made and the taxpayer has net capital gains in the 15%, 20%, and 28% rate categories, those subject to the 15% and 20% rates are treated as ordinary income before those subject to the 28% rate (Sec. 1(h)(4)).
Obviously, an election should not be made if a taxpayer has sufficient other current - year net investment income to allow a deduction of all investment interest expense. Because disallowed investment interest expense carries over indefinitely, deciding whether to make the election may require an analysis that includes a number of future tax years. Key factors in making the decision are (1) current and future (anticipated) marginal tax rates, (2) expected net investment income (excluding net capital gains and qualified dividends) and investment interest expense for future tax years, and (3) the taxpayer's discount rate or factor for computing his or her time value of money. With this information, a reasonable present - value analysis can be done to determine whether the election is beneficial. Of course, the amount of disallowed investment interest expense would determine whether an extensive analysis is necessary and cost - effective .
Example 1. Electing to include net capital gains in investment income: For 20X1, J has $250,000 of taxable income, files as single, and is in the 32% tax bracket. He is subject to the 3.8% net investment income tax since his taxable income exceeds $200,000. J's income includes $2,000 of interest income and $6,500 of net long - term capital gain. He also has $5,000 of investment interest expense from broker margin accounts. He expects his 20X2 income and deductions to be similar to 20X1. Without an election, J can deduct $2,000 of his 20X1 investment interest expense and carry forward the remaining $3,000 indefinitely.
The decision on whether to make the election may depend on the applicable capital gain rate. If the election causes gain subject to the 31.8% (28% + 3.8% net investment income tax) rate (e.g., collectibles gain) to be treated as ordinary income, no significant tax benefit is received by carrying the deduction over to 20X2. (The best he could do is receive a 32% tax benefit, assuming the interest is deductible in 20X2, rather than the net 31.8% tax benefit he could receive by electing to include a portion of the long - term gain in investment income in 20X1.) Thus, it is probably better for J to make the election in 20X1 and treat $3,000 of the net capital gain as investment income. The $6 ($3,000 × [32% − 31.8%]) of additional tax paid on the net capital gain is offset by a $960 ($3,000 × 32%) tax savings from the additional interest expense deduction. Thus, the actual 20X1 tax benefit realized from the additional deduction is 31.8%, or $954.
However, if the election affects a $3,000 gain subject to the 18.8% (15% + 3.8% net investment income tax) capital gain rate, the cost of making the election increases. If the election is made, J must pay additional tax of $396 ($3,000 × [32% − 18.8%]) on the capital gain. Thus, making the election to claim the deduction in 20X1 results in net tax savings of only $564, an 18.8% tax benefit ([$3,000 × 32%] − $396). By not making the election and carrying the deduction forward, J may be able to increase his tax savings from the deduction to $960, a 32% tax benefit in 20X2. Thus, forgoing the election may be the preferred strategy in this case.
Similarly, if J expected his 20X2 investment income to increase so that the investment interest carryover would be deductible in 20X2 and he expected his 20X2 taxable income to increase significantly so that he would be in a higher tax bracket, a decision to forgo the election and defer the deduction to 20X2 is probably the better choice.
Example 2. Present-value analysis aids in election decision: In 20X1, L paid $30,000 in investment interest expense and has interest income of $10,000 and net capital gains of $20,000, all subject to a 23.8% (20% + 3.8% net investment income tax) capital gains rate. He files single and is in a 45% (including 3.8% net investment income tax) combined federal and state tax bracket. In 20X2, he will pay off his investment debt so he will have little or no investment interest expense that year, and he expects his interest income that year to total $20,000. He expects to be in a 40% combined tax bracket in 20X2. He uses a 6% discount rate in analyzing his investments.
Here, a present - value analysis makes sense because of the amount of investment interest involved and the taxpayer's changing tax rates for the affected years. The analysis helps quantify the effects of making the election to include net capital gains in net investment income in 20X1. The table "L's Investment Income and Interest Expense in Example 2" summarizes L's tax situation for the investment income and investment interest expense based on his projections for 20X2.
If no election is made, L will pay $4,760 tax on his interest and capital gain in 20X1. If the election is made, the tax is shifted to 20X2 but amounts to $8,000. If the $8,000 tax for 20X2 is discounted back to 20X1 using a 6% discount factor, the result is $7,547. (See the table " Present - Value Computation in Example 2.") Thus, L saves $2,787 ($7,547 − $4,760) by not making the election. The result might be somewhat different if L were not able to realize a tax benefit from the disallowed interest expense until tax years after 20X2 or his 20X2 tax rate bracket was less than 40%.
This case study has been adapted from Checkpoint Tax Planning and Advisory Guide's Individual Tax Planning topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).
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